In this "What's Up, Bro?" segment from the episode of Motley Fool Answers, Robert Brokamp explains how the two components of your retirement account influence the final amount of money you'll have in retirement. Contributions are very important when starting out, but as Robert explains, eventually investment returns become far more significant -- and just 2% can make a massive difference over the long term.
A full transcript follows the video.
This video was recorded on April 10, 2018.
Alison Southwick: So, Bro, what's up?
Robert Brokamp: Well, Alison, as you know, your retirement savings will be made up of two components, and that is the amount that you save and contribute to those accounts, and then the investment returns that you earn in those savings. But at different stages in your life, one will be more important than the other, so when you're starting out, the amount that you save will by far have the biggest impact on your account balances. But as those accounts get bigger, investment returns become more important and at some point, they'll have a bigger influence on the ultimate amount that you have for retirement.
But at what point does that happen? When does that crossover point occur? Well, it turns out that a recent article in Money magazine by Walter Updegrave provided an answer based on a hypothetical worker who makes $45,000 a year, gets a 2% raise each year, saves 10% of her salary, and earns 6% annually on her investments. So, here are the numbers according to Walter.
After that first year, investment returns are not a big factor. They account for just $20 a month or 5% of the total. Again, getting money into the account is what's important. But by year eight things start to change. Returns equal more than half of the monthly contributions and then a little more than 13 years into saving for retirement, that's when you reach the crossover point. Investment gains exceed the amount that you contribute to the account, at least based on this scenario, and then it just snowballs from there.
23 years in, gains are doubling the amount that you save. By year 30 gains are tripling the amount. Year 35, gains are counting for four times more than you put into the account, and then by year 38 gains are five times bigger than the contributions.
What are the key takeaways? First, when you're young, focus your energies on saving as much as possible, and that includes what you put in but also making sure that you're taking advantage of the employer match. Not surprisingly, the person who saves 10% of her salary will have twice as much for retirement as the person who saves just 5%. That's the math.
One of my roles, here, at the Fool is meeting with individual employees who have retirement questions or any sort of financial questions, and I'm often meeting with new employees. They tend to be young and they don't know a lot about personal finances or investing. They come in and ask what they should be prioritizing, and I always tell them at that stage focus on budgeting. Focus on finding ways to save money. You ideally want to be saving 15% total out of the gate when you start saving for retirement.
But gradually, you've got to learn to be an excellent investor because the investment returns that you earn eventually will have a huge impact. In that first year you're saving whether you earn 6% or 8% or 10% really doesn't matter. But at some point, earning just 2% or more a year on your portfolio, especially over the long term, is going to add up to tens of thousands of dollars.
Another lesson, here, is that it's a different way of thinking about the importance of starting early. If you start at 25 -- according to this scenario that Updegrave created -- you'll be just 38 at the point that your portfolio is doing more of the heavy lifting. But if you wait until you're 35 to start, you're going to be almost 50 by the time returns exceed contributions and for many people, they'll have to compensate by either saving more or retiring later.